Another red flag bites the dust – stock based comp
Listed companies that exclude stock base compensation (SBC) from their adjusted profit numbers may see pressure to reverse the policy following the move by one of the globe’s biggest listed companies, the $573bn market cap Google parent company Alphabet. CFO Ruth Porat stated on their most recent results call that they consider SBC to be “a real cost of running our business” and that going forward they will no longer exclude it from their adjusted non-GAAP earnings, lifting the company’s PE ratio on adjusted earnings by 25%.
Back in April 2016 we listed SBC as a red flag for investors. Fundamental investors mistrust companies that exclude SBC from adjusted profit figures, often buying back the shares to avoid share count dilution from the issue of shares to employees. Many, mostly TMT, companies with material SBC expense do this, but there seems to be little rationale other than that everyone else does it.
Alphabet is not the first big company to make this move. As Richard Waters points out in the Financial Times, Amazon already adopted this practise in its adjusted figure disclosure. But Amazon is still really a pre-profit company and investors don’t focus so much on that metric. Older tech companies Apple and Microsoft never reversed out SBC, but it is also relatively low impact at circa 2% of sales. For Alphabet, the new disclosure lowers it’s adjusted 2016 EPS by 20%, or put another way raises its headline PE ratio by 25%.
The argument for excluding SBC from adjusted earnings was that it is a non-cash figure, and that anyway the underlying numbers are there for all to see in notes to accounts. Neither of these arguments stand up to scrutiny.
Share based compensation means value is being transferred from the shareholders to employees, and this should not be ignored when looking at the annual results of a business. Many companies buy-back stock to fund their share schemes, so there is a real cash outflow, but not shown in the income statement or even in free cash flow. The alternative is an ever expanding number of shares, gradually diluting shareholder value.
Relegating the detail to the notes-to-the-accounts has left just about every stock analyst quoting PE and other ratios based on company adjusted figures. Not a great endorsement of that profession, or of the herds of investors who seem to accept this behaviour.
The FT describes this as a watershed moment. Contact us if you’d like help removing those red-flags that put off fundamental investors.
Oakhall was established by top-rated equity research analysts to help chairpeople, CEOs and CFOs better analyse their own business and strategies, and articulate them to stakeholders. Founder Andrew Griffin spent almost two decades as a technology equity analyst, ultimately as managing director of European technology equity research at Bank of America Merrill Lynch, before working in investor relations, corporate development and market intelligence for a UK listed software company.